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Monday, February 28, 2011

Christina Romer has an Op-Ed on U.S. monetary policy that raises several important points. First, she does a good job explaining that monetary policy can still pack a punch even when short-term interest rates are close to zero. She reminds us that unconventional monetary policy during the Great Depression--the original QE program--did wonders for the economy in a far worse economic environment than today. If it did such an incredible job back then, why couldn't it do the same today? This is a point I made late last year to Paul Krugman. It should encourage folks like him and Mark Thoma to be more optimistic about what monetary policy can do to shore up the recovery.

Second, Romer explains why U.S. monetary policy is not doing more given its untapped potential. She attributes this failure to to a polarizing division among two types of policymakers: empiricist and theorist. Here is how she describes them:

Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal.

Though there is much debate about what level of unemployment is now normal, virtually no one doubts that at 9 percent, unemployment is well above it. With core inflation running at less than 1 percent, empiricists are therefore relatively unconcerned about inflation in the current environment.

Theorists, on the other hand, emphasize economic models that assume people are highly rational in forming expectations of future inflation. In these models, Fed actions that call its commitment to low inflation into question can cause inflation expectations to spike, leading to actual increases in prices and wages.

For theorists, any rise in an indicator of expected or future inflation, like the recent boom in commodity prices, suggests that the Fed’s credibility is at risk. They fear that general inflation could re-emerge quickly, despite high unemployment

I don't like this division. It creates the impression that all empiricists don't use foward-looking theory to asses their reading of the data. Far from it. Take, for example, the core inflation measurement mentioned above. The only reason policymakers look to this is because it provides an indicator of where trend inflation is headed. Also, many empiricists look to explicit forward-looking market measures found in various assets prices. The most obvious one is the expected inflation series that comes from the spread between yields on nominal and real treasury securities. Empiricists are looking to these forward looking measures and see no runaway inflation on the horizon. For example, below is the expected inflation term structure--the expected inflation rate across various forecast horizons--from the Cleveland Fed. This data is a cleaned-up version of the expected inflation series implied by treasury securities.

This figure shows that since QE2 1-year inflation expectations have gone from 0.90% to 1.80% while 10-year inflation expectations have gone from 1.55% to 1.82%. These numbers are low relative to the implicit 2.00 to 2.50% inflation target of the Fed. Empiricists care about these indicators because they understand the importance of keeping them anchored. So far, though, there is no sign of them becoming unanchored. If any thing, the theoretically-driven empiricists see a reanchoring of inflation expectations that is pulling them down and preventing a more robust recovery.

So what is the solution? Christina Romer suggests a price level target. It would be a vast improvement over QE2 in terms of efficacy and it would add more long-run certainty. However, for the reasons outlined here, an even better alternative would be a nominal GDP level target.

Caroline Baum has five questions for Fed Chairman Ben Bernanke when testifies to Congress on March 1-2. She has great questions for Bernanke and I hope someone in Congress will ask them. Here is one more question I would like to see Congress ask Bernanke:

"Chairman Bernanke, the minutes of the September, 2010 FOMC meeting show that nominal GDP targeting was discussed. Other observers have also been discussing the idea. What are your thoughts on nominal GDP targeting as a way to conduct U.S. monetary policy?"

If case anyone is interested, here are some posts that make the case for a nominal GDP level target:

Inflation targeting has been taking a beating across the Atlantic. In the United Kingdom, where there is an explicit inflation target, it appears the Bank of England is getting ready to tighten monetary policy despite ongoing economic weakness. The reason for the expected tightening is rising inflation, even though the recent increases may be a one-off event. Nonetheless, because of its inflation target the Bank of England seems set to reign in aggregate demand regardless of the consequences for the economy.

This makes little sense. Nick Rowe notes that this experience raises tough questions for those who believe that monetary policy that stabilizes inflation will also tend to stabilize economic activity. Scott Sumner goes says this experience shows the failure of inflation targeting. I say it definitely gives inflation targeting a black eye, but it had it coming. Inflation targeting is an imperfect approach to monetary policy that only works when certain conditions hold. It was inevitable that at some point those conditions would not hold. That seems to be the case in United Kingdom.

So why is inflation targeting an imperfect approach to monetary policy? First, it treats all changes to the inflation rate the same. Inflation targeting fails to distinguish between inflation rate movements arising from aggregate demand (AD) shocks and those coming from aggregate supply (AS) shocks. This can be destabilizing because monetary policy should ignore AS shocks but respond to AD shocks. Too see this, assume Y2K actually turned out to be hugely disruptive for a prolonged period. This negative AS shock would reduce output and increase prices. An inflation-targeting central bank would have to respond to this negative AS shock by tightening monetary policy, further constricting the economy. Conversely, say there is a new technology that makes computers super fast so that productivity soars. This would tend to lower the inflation rate and increase the neutral interest rate. Here, an inflation-targeting central bank would ease monetary conditions to maintain its inflation target. This, however, would require lowering the policy interest rate even though the neutral rate was increasing. Monetary policy would be too loose and a boom could ensue.

Now if all shocks were AD shocks then all inflation movements would be AD-driven and inflation targeting would make more sense. For example, if inflation rose above target because AD was growing too fast then the central bank could respond appropriately with inflation targeting. In the real world, however, there are both AD and AS shocks. Inflation targeting's failure to distinguish between the two sources of inflation makes it bound to have problems.

A second problem with inflation is that even if it were responding to an AD shock, it has "no memory." That is, if a central bank targets inflation and the economy actually undergoes several periods of deflation there is no making up the inflation shortfall once inflation returns to its target. It is as if the decline in the price level was "forgotten" by the monetary authorities. Such a decline causes problems because households and firms prior to the deflation entered into nominal contracts with expected inflation that was based on the inflation target holding. The absence of any catch-up inflation means there will be an permanent transfer of wealth that was unexpected.

The obvious answer to my second critique of inflation targeting is to adopt a price level target that does take into account past misses. While this would be an improvement over inflation targeting it too fails to distinguish between AD and AS shocks. So while a price level target might improve our current plight it is bound to get a black eye in the future too. What is needed, then, is a monetary policy rule that (1) ignores AS shocks but responds to AD shocks and (2) does so with "memory." Is there anything out there that fits this billing? The answer is nominal GDP level targeting. This approach aims to stabilize total current dollar spending (i.e. nominal spending) around some targeted growth path. If nominal spending falls below trend growth there is catch up growth in the subsequent periods and vice versa. This is not a new idea and was even discussed by the FOMC in its September, 2010 meeting. See here, here, here, and here for some of my past writings on this idea. If Congress wants to really narrow the mandate of the Fed in a constructive way it should consider nominal GDP level targeting.

Monday, February 21, 2011

Ben Bernanke delivered a speech Friday where he further developed his global saving glut (GSG) hypothesis. This view holds that the reason for the low long-term interest rates in the United States during the early-to-mid 2000s was that desired saving vastly exceeded desired investment in emerging economies. Consequently, capital flowed from these countries to the U.S. economy and pushed down long-term interest rates. The cheaper credit in turn fueled the U.S. housing boom. Based on a new research paper, Bernanke extends his GSG hypothesis by considering the type of assets desired by these emerging economies as they invested in the U.S. economy. He shows that investors from these countries, as well as from Europe, had a strong appetite for AAA-rated assets which were in short supply elsewhere. Given the limited supply of Treasury and agency securities, the U.S. financial system responded by transforming risky assets into safe assets.

And so, we have a theory that nicely ties together global economic imbalances, developments in structured finance, and the U.S. housing boom. Note, though, that the GSG hypothesis places no culpability on the Fed. Instead, blame is placed on the failings of the U.S. private sector and foreigners who save too much. How convenient for Ben Benanke and the Fed. I am trying to be open minded here but really, how can one not view this self-serving explanation with some skepticism? Is this speech really about shedding light on the housing boom or is about defending the Fed? Robin Harding of the FT thinks it is the later:

Mr Bernanke’s goal, I think, is to strike another blow in the long-running argument about whether it was foreign currency manipulation/excess savings or bad US monetary policy that caused US interest rates to be so low in the middle of the last decade and thus stoked the housing bubble.

But let's give Bernanke benefit of the doubt. Maybe he is just extending his GSG hypothesis and is not trying to absolve the Fed of responsibility for the housing boom. If so, it would do a world of good if he would actually address the tough questions that skeptics like me have about the GSG hypothesis. In case he is reading, here are the questions.

(1) Wasn't some of the excess saving coming from the emerging economies simply recycled U.S. monetary policy? As Bernanke's speech suggests and as acknowledged by other Fed officials including Janet Yellen, the Fed is a monetary superpower. It controls the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across much of the globe. This means that the other two monetary powers, the ECB and the Bank of Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well.

In the early-to-mid 2000s, those dollar-pegged emerging economies pegged were forced to buy more dollars when the Fed loosened monetary policy. These economies then used the dollars to buy up U.S. debt. This channeled credit to the U.S. economy and pushed down interest rates. To the extent the ECB and the Bank of Japan were also responding to U.S. monetary policy, they too were acquiring foreign reserves and channeling credit back to the U.S. economy. Thus, the easier U.S. monetary policy became the greater the amount of recycled credit coming back to the U.S. economy.

Now this doesn't mean all of the foreign reserves buildup was due to U.S. monetary policy. There are both precautionary and mercantilist reasons for the accumulation of foreign reserves. U.S. monetary policy affects foreign reserves buildup through the latter one. The question, then, is how important was the mercantilist motive? The two figures below suggest it was and still is sizable. The first figure shows the year-on-year growth rate of global foreign reserves along with the Taylor rule gap. This gap is the difference between the Taylor-rule prescribed federal fund rate and the actual federal fund rate. In other words, the Taylor rule gap provides a measure of the stance of U.S. monetary policy.

The next figure shows the scatterplot of these two series:

This latter figure indicates that about half of the foreign reserves buildup can be tied to the stance of U.S. monetary policy via the mercantilist motive. Now this is not conclusive evidence, but at a minimum it should give GSG supporters pause. It seems that a sizable portion of the saving glut was simply recycled U.S. monetary policy.

(2) Didn't the Fed itself create some of the increased demand for safe assets by pushing short-term interest rates super low and promising to hold them there for a "considerable period?" When the Fed pushed interest rates low, held them there, and promised to keep them there for a "considerable period" it created new incentives for the financial system. First, via the expectations hypothesis (which says long-term interest rates are simply an average of short-term interest rates over the same period plus a term premium) these developments pushed down medium to longer yields as well, as seen in the figure below:

As Barry Ritholtz notes, this drop in yields caused big problems for fixed income fund managers who were expected to deliver a certain return. Consequently, there was a "search for yield" or as Ritholtz says these managers of pension funds, large trusts, and foundations had to "scramble for yield." They needed a higher but relatively safe yield in order to meet their expected return. The U.S. financial system meet this rise in demand by transforming risky assets into safe, AAA-rated assets.

The Fed's low interest rate policies also increased the demand for safe assets for hedge fund managers. For them the promise of low short-term interest rates for a "considerable period" screamed opportunity. As Diego Espinosa shows in a forthcoming paper, these investors saw a predictable spread between low funding costs created by the Fed and the return on higher yielding but safe assets. They too wanted more AAA-rated assets to invest in so that they could take advantage of this spread that would be around for a "considerable period." Here too, the U.S. financial system responds by transforming risky assets into safe assets.

(3) Why doesn't the GSG hypotheis fit the data after 2005? If the huge CA surpluses (which reflect the global saving glut) coming from the emerging economies did, in fact, lead to the lowering of long-term rates in the U.S. economy, which in turn fueled the housing boom, why did long-term rates stop falling in 2004 and start rising in 2005? As the figure below shows, the U.S. CA deficit as a percent of GDP (red line) falls through 2006 and remains large through early 2007. The 30-year mortgage rate, on the other hand, stabilizes in 2004 and starts increasing in 2005. How is it that the saving glut could fuel low rates in the early-to-mid 2000s but not thereafter?

(4) Was the U.S. economy really a slave to the emerging economies during the early-to-mid 2000s? The GSG hypothesis has an underlying theme of inevitability. The implicit message is that the U.S. was destined to be a profligate spender because of the huge CA surpluses in Asian and oil-exporting countries. Really? Why couldn't monetary or fiscal policy have tightened during this time? Were U.S. policymakers truly constrained by the whims of foreign savers? This inevitability theme seems strange now that these same countries are complaining about the uneven impact of QE2 and begging the Fed for mercy. So what is it: is the U.S. economic policy a slave to the emerging economies or are the emerging economies a slave to the U.S. policy?

I look forward to hearing Chairman Bernanke's response to these questions.

Thursday, February 17, 2011

According to Jim Hamilton, the answers is yes. He shows that the average maturity of publicly-held U.S. debt continues to grow despite the Fed's QE2 program. This should not be the case. Under QE2, the Fed is purposefully trying to lower the average maturity of Treasury securities for reasons that will be explained later. The fact that the Fed is not shortening the average maturity means that the Treasury is issuing long-term debt faster than the Fed is buying it up. Nonetheless, there is still evidence that that QE2 is having an effect on nominal and real expectations as seen here. Thus, the U.S. Treasury Department has not completely thwarted the Fed's efforts, but it is surprising to see fiscal policy and monetary policy working against each other here.

So why does the average maturity of Treasury securities matter? The standard answer is that if the Fed reduces the average maturity then there will be a drop in the net supply of long-term Treasuries. This will cause their prices to go up and their yields to drop. The drop in yields, in turn, would affect interest sensitive spending. This interest rate effect, however, is only part of a bigger, richer story that gets overlooked. This bigger story is how the shortening of the average maturity will lead to a rebalancing of assets in investors' portfolios and, in so doing, affect nominal spending. This rebalancing story is the portfolio balancing channel of monetary policy.

The portfolio balancing story goes as follows. Currently, short-term Treasury debt like T-bills are near-perfect substitutes for bank reserves because both earn close to zero percent and have similar liquidity. In order for the Fed to get investors to spend some of their money holdings it must first cause a meaningful change in their portfolio of assets. Swapping T-bills for bank reserves will not do it because they are practically the same now. In order to get traction, the Fed needs to swap assets that are not perfect substitutes. In this case, the Fed has decided to buy less-liquid, higher-yielding, longer-term Treasury securities. Doing so should lower the average maturity of publicly-held U.S. debt. It should also overweight investor's portfolios with highly-liquid, lower-yielding assets and force investors to rebalance them. In order to rebalance their portofolios, investors would start buying higher-yielding assets like stocks and capital. This would ultimately drive up consumption spending--through the wealth effect--and investment spending. The portfolio rebalancing, then, ultimately cause an increase in nominal spending. Given the excess economic capacity, this rise in nominal spending should in turn raise real economic activity.

My description of the portfolio channel so far ignores the importance of expectations. If the Fed could convince investors that it is committed to the objective of higher nominal spending and higher inflation (say through an explicit nominal GDP target) then much of the rebalancing could occur without the Fed actually buying the securities. For if investors believe there will be a Fed-induced rise in nominal spending that will lead to higher real economic growth and thus higher real returns, they will on their own accord start rebalancing their portfolios toward higher yielding assets. Likewise, if investors anticipate higher inflation, then the expected return to holding money assets declines and causes them to rebalance their portofolios toward higher yielding assets. In other words, by properly shapping nominal expectations the Fed could get the market to do most of the heavy lifting itself. I believe this is why QE2 is still having some effect despite the Treasury working against it.

To put this portfolio rebalancing issue in perspective, it is useful to see how the combined portfolios of households and non-financial firms are weighted toward highly liquid assets. Using the Flow of Fund data, the figure below shows for the combined balance sheets of households, non-profits, corporations, and non-corporate businesses the percent of total asset that are highly liquid ones (i.e. cash, checking accounts, saving and time deposits, and money market funds) as of 2010:Q3: (Click on figure to enlarge.)

The figure shows that the spike in demand for liquid assets that began in the 2008 financial crisis remains elevated through 2010:Q3. This is why there is still an aggregate demand (AD) problem. The nonfinancial private sector is still reluctant to spend its money holdings--there appears to still be an excess money demand problem. The Fed' s job, then, is start a rebalancing of portfolios that is vigorous enough to bring the holdings of money assets more into line with historical trends. Once this happens the aggregate demand shortfall should disappear.

P.S. It will be interesting to see what has happened to the above figure once 2010:Q4 data comes out. Given the rise in inflation expectations and the improved economic outlook, we should see some meaningful adjustment to share of assets held as money.

Friday, February 11, 2011

Tyler Cowen responds to some of the Great Stagnation critics by pointing to trends in total factor productivity (TFP):

The critical responses to The Great Stagnation prefer to attack median income measures and in general they are reluctant to talk about total factor productivity. Yet we are pointed very much toward the same conclusion.

The point is that the Great Stagnation theory matches nicely with the standard story of TFP growth: there was a "golden age" of TFP growth during the1948-1973 period, but thereafter it stalled until about 1995. That is an interesting rebuttal from Cowen, but haven't we made some impressive TFP gains since 1995 given the advances in technology? To see just how marked this TFP decline was after 1973 and whether the recent TFP gains make up for any of the loss, I went to the data. Below is a figure constructed using the quarterly TFP series of John Fernald at the San Francisco Fed. (Click on figure to enlarge.)

Okay, I am impressed and far less skeptical of the Great Stagnation theory. In my previous post I argued that Cowen failed to appreciate how dramatically our lives have changed since the advent of the internet and faster computing. Now I am thinking these gains are but a faint shadow of what they could have been had TFP continued to grow at its 1947-1973 trend. The "good old days" really were better in terms of TFP growth.

Still, I wonder how much of the true, underlying TFP gains are being measured given the large share of our economy that is in the service sector, where output and productivity are hard to measure. Also, I am optimistic that we are on the cusp of a Great Acceleration for the global economy. Technological gains continue and the rest of the world's catch up growth is bound to create positive spillover effects for the advanced economies. As I mentioned before, imagine what will happen to R&D funding on cancer and AIDS once several billion Asians are rich enough to start demanding it. (In fact, they may be a big part of the solution to U.S. health care problems.) This HSBC report also makes the case for an impending Great Acceleration. I am optimistic about the future.

Tuesday, February 8, 2011

I have been reading with interest the discussion surrounding Tyler Cowen's new book, The Great Stagnation. The main argument of the book is that the technological progress has slowed. We have picked the "low-hanging fruit" of economic growth and now are mired in slow growth. Count me a skeptic on this one. I believe we have just gone through one of the greatest technological innovations of our time with the advent of the internet and faster computing. Moreover, these technologies are still improving and the potential positive spillover effects from the rest of the world catching up with the advanced economies are tremendous (e.g. imagine what will happen to R&D funding on cancer and AIDS once several billion Asians are rich enough to start demanding it). Rather than a great Stagnation, I see us at that cusp of a Great Acceleration.

Regarding the past few decades, Cowen cites the decline in median income to support his thesis. I can only cite anecdotal evidence, but it is highly convincing to me. The evidence is this: ask yourself how much more productive you are today than you were before the internet and faster computing. In all areas of my life--work, family, travel, enertainment, religion, health, recreation, etc.--I can come up with many examples of where I am now more efficient (or at least have the potential to be more efficient). Some of these gains get reflected in official statistics. Many, however, do not as they are hard to measure. This is not surprising since most of these gains are in the service sector of the economy, a sector where output and productivity have been notoriously hard to measure. For this reason, I believe the data understates the economic gains over the last few decades.

To rectify this measurement problem, I thought I would make an exhaustive list of the all the productivity gains in my life that are the result of the internet and faster computing. But then I realized, one, nobody would want to see them and, two, CTU's Jack Bauer could do a much better job than I ever could. Yes, the famed counterterrorism agent from the show 24 knows first hand how much more effective he is at getting the terrorists because of these gains. You see, he tried his hand at counterterrorism in 1994 and was not too successful because the technology just was not there. Here is a video clip that documents his problems:

While humorous, this video clip makes it very clear why I find it hard to buy into the Great Stagnation Hypothesis.

Thursday, February 3, 2011

Bernanke responds today to the accusation that the commodity price boom is being caused by U.S. monetary policy:

Supply and demand abroad for commodities, not U.S. monetary policy, are causing higher food and energy prices rattling much of the world, Federal Reserve Chairman Ben Bernanke said Thursday. “The most important development globally is that the world is growing more quickly, particularly in emerging markets,” Bernanke said in response to a question after his speech at the National Press Club...“I think it’s entirely unfair to attribute excess demand in emerging markets to U.S. monetary policy,” Bernanke said. Those nations can use their own monetary policy and adjust exchange rates to deal with their inflation problems, he said. “It’s really up to emerging markets to find appropriate tools to balance their own growth.”

Scott Sumner and Paul Krugman would agree with this assessment. Here is an update figure from an earlier post that shows the year-on-year growth rates of industrial production in emerging economies and the CRB Commodity Spot Index: (Click on figure to enlarge.)

For some time now, I have been making the case that a sign of QE2 success would be rising yields rather than falling yields. Yes, interest rates may initially fall, but if QE2 is successful in raising expectations of real growth then interest rates should start to increase. For example, back in December, 2010 I said the following:

If QE2 is successful, then we would expect treasury yields to rise! A successful QE will first raise inflation expectations. This alone will put upward pressure on nominal yields. However, expectations of higher inflation are in effect expectations of higher nominal spending. And higher expected nominal spending in an economy with sticky prices and excess capacity will lead to increases in expected real economic growth. The expected real economic growth should in turn increase real yields. It is that simple.

Here is an updated graph from a more recent post that indicates this is in fact happening:

Given this understanding, it has been frustrating to watch the Fed sell QE2 to the public as working through the lowering of interest rates. This marketing of QE2 creates the false impression it will only work if yields remain low. It gives critics of QE2 more ammunition and ultimately undermines the effectiveness of the program. Thus, I was please to see Bernanke say this today in his speech:

A wide range of market indicators supports the view that the Federal Reserve's securities purchases have been effective at easing financial conditions... Yields on 5- to 10-year Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases. All of these developments are what one would expect to see when monetary policy becomes more accommodative.